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The cheapest and most effective firewall in the world

While the European crisis has escalated ECB officials have continued to stress that the ECB’s mandate is to ensure inflation below, but close to, 2%.

Lets assume that we have to come up with a monetary policy response to the European crisis that fulfils this condition.

I have a simple idea that I am confident would work. My idea is a put on inflation expectations or what we could call a velocity put.

A number of European countries issue inflation-linked bonds. From these bonds we can extract market expectations for inflation. These bonds provide the ECB with a potential very strong instrument to fight deflationary risks. My suggestion is simply that the ECB announces a minimum price for these bonds so the implicit inflation expectation extracted from the bonds would never drop below 1.95% (“close to 2%”) on all maturities. This would effectively be a put on inflation.

How would the inflation put work?

Imagine that we are in a situation where the implicit inflation expectation is exactly 1.95%. Now disaster strikes. Greece leaves the euro, a major Southern Europe bank collapses or a euro zone country defaults. As a consequence money demand spikes, people are redrawing money from the banks and are hoarding cash. The effect of course will be a sharp drop in money velocity. As velocity drops (for a given money supply) nominal (and real) GDP and prices will also drop sharply (remember MV=PY).

As velocity drops inflation expectations would drop and as consequence the price of the inflation-linked bond would drop below ECB’s minimum price. However, given the ECB’s commitment to keep inflation expectations above 1.95% it would have either directly to buy inflation linked bonds or by increasing inflation expectations by doing other forms of open market operations. The consequences would be that the ECB would increase the money base to counteract the drop in velocity. Hence, whatever “accident” would hit the euro zone a deflationary shock would be avoided as the money supply automatically would be increased in response to the drop in velocity. QE would be automatic – no reason for discretionary decisions. In fact the ECB would be able completely abandon ad hoc policies to counteract different kinds of financial distress.

This would mean that even if a major European bank where to collapse M*V would basically be kept constant as would inflation expectations and as a consequence this would seriously reduce the risk of spill-over from one “accident” to another. The same would of course be the case if Greece would leave the euro.

This is basically a similar policy to the one conducted by the Swiss central bank, which has announced it will not allow EUR/CHF to drop below 1.20. This mean an increase in money demand (which would tend to strengthen the Swiss franc) will be counteracted by an automatically increase in the money base if EUR/CHF would inch below 1.20.

Chuck Norris to the rescue

The Swiss experience clearly shows that a clearly stated and credible policy like the 1.20-target has some very clear advantages. One major advantage has been that the SNB have had to do significantly less intervention in the market than prior to the announcement of the policy. In fact the Swiss money base initially dropped after the introduction of the 1.20-target. This is the Chuck Norris effect of monetary policy – monetary policy primarily works through expectations and the market will do most of the lifting if the policy is clear and credible.

There is no reason to think that Chuck Norris would not be willing to help the ECB in the case it announced a lower bound on implicit inflation expectations. In fact I think inflation expectations would jump to 1.95% at once and even if Greece where to leave the euro or a major bank would collapse inflation expectations and therefore also velocity would remain stable.

This would in my view be an extremely simple but also highly effective firewall in the case of new “accidents” in the euro zone. Furthermore, it would likely be a very cheap policy. In addition there would be a build-in exit strategy. If inflation expectations moved above 1.95% the ECB would not conduct any “extraordinary” policy measures. Hence, the policy would be completely rules based and since it would target inflation expectations just below 2.0% no could hardly argue that it would threaten price stability. In fact as it would ensure against deflation it would to very large extent guarantee price stability.

Furthermore, the ECB could easily introduce this policy as a permanent measure as it in no way would conflict with the over policy objectives. Nor would it create any problems for the use of ECB’s traditional policy instruments.

I would of course like a futures based NGDP level targeting regime implemented in the euro zone, but that is very unlikely to find any support today. However, I would hope the ECB at least would consider introducing a velocity put and hence significantly contribute to financial and economic stability in the euro zone.

PS if the ECB is worried that it would be intervening the the sovereign bonds market it could just issue it’s own inflation linked bonds. That would change nothing in terms of the efficiency of the policy. The purpose is not to help government fund their deficits but to stabilise inflation expectations and avoid a deflationary shock to velocity.

PPS My proposal is of course a variation of Robert Hetzel’s old idea that the Federal Reserve should ensure price stability with the use of TIPS.

12 Comments

Targeting the spread between regular and indexed bond yields is so clearly the right path, that it will never happen. Not only does it more or less act as an NGDP level target, it can be easily explained to people stuck in the New Keynesian/Taylor rule framework.

But just like Milton Friedman’s M2 rule, it doesn’t give Central Bank’s anything to do! Surely they wouldn’t need all those extra researchers, or interviews before parliaments with a market CPI futures target…

JP Koning

Interesting idea, Lars. One problem here is that the TIPS spread (I’ll use US lingo if you don’t mind) measures not only expected inflation but also the relative illiquidity of TIPS relative to Treasuries. It measures, in part, a liquidity premium.

TIPS might fall to the central bank’s minimum buying price not because inflation expectations have fallen, but because the liquidity of TIPS relative to Treasuries has declined. This change in liquidity could be purely incidental. ie. it could be due to some unimportant technical change unique to Treasury markets. The result would be that the central bank buys up TIPS because it believes inflation expectations have fallen, when in actuality it is the liquidity premium that has changed. According to your rule, the money supply automatically increases, though perhaps it shouldn’t have.

In short, you have to find some way to decompose that portion of the spread between TIPS and Treasuries that is due to the liquidity premium and that which is due to inflation expectations.

It there were publicly traded “liquidity-options” on TIPS, you’d be able price the value of the liquidity premium and use that to back out that portion of the TIPS spread due purely to inflation expectations. Then you could apply your rule more precisely.

Yes, it is correct that there probably is a liquidity premium in linkers/TIPS, but that is not a major problem. The pricing is probably also distorted by tax issues, but overall if implicit inflation expectations gives a pretty good indication of inflationary/deflationary pressures and even if the level might be 25-50bp “wrong” that does not really matter because the change in inflation expectations would be most important. Anyway, it would be relatively easy to adjust for these problems. The ECB could ask an independent panel of experts once every quarter what the liquidity premium was an then adjust its targeted minimum inflation expectations for that.

Furthermore, the sharp drop in implicit inflation in the US in 2008 is often said to have been excessive due to liquidity issues. My answer to that is: So what? Would anybody really have mind if the Fed had more aggressively than it did?

Finally if the ECB indeed put a minimum prices on inflation linked bonds in the euro zone that in itself was likely reduce the liquidity premium.

So yes, there are problems, but compared to the kind of issues we are facing in the euro zone right now that is really minimal and quite easy to get around.

JP Koning

“The ECB could ask an independent panel of experts once every quarter what the liquidity premium was an then adjust its targeted minimum inflation expectations for that.”

Isn’t this just bringing in non-market monetarism in by the back door?

“Furthermore, the sharp drop in implicit inflation in the US in 2008 is often said to have been excessive due to liquidity issues. My answer to that is: So what? Would anybody really have mind if the Fed had more aggressively than it did?”

Good point. 2008 was a broad liquidity event. I am thinking about very specific changes in liquidity – those unique to Treasury markets.

“Finally if the ECB indeed put a minimum prices on inflation linked bonds in the euro zone that in itself was likely reduce the liquidity premium.”

I agree. It might even make the liquidity premium switch in favor of inflation-linked bonds. But without some sort of price for the premium, it’s hard to say what it’s ultimately worth.

“So yes, there are problems, but compared to the kind of issues we are facing in the euro zone right now that is really minimal and quite easy to get around.”

Yes, if you are looking for immediate solutions, details are not that important. I am thinking more about what happens after there is a stabilization. The TIPS-put policy during normal times would surely require fine-tuning to account for the liquidity premium, and using market derived prices to account for it is the best solution.

Petar Sisko

Hi people, I know its been several months since this topic was published, unfortunately I saw it just a few days ago, and i remembered this comments today. I see you were talking about a liquidity premium. It is very possible that I am wrong, but would bid-ask spread be a way to measure liquidity premium in a way?